There are few things in life as murky as tax law. There’s a lot of misinformation floating around about how you’re taxed on the profit (capital gains in IRS-speak) you make when you sell your home. Plus, this topic made news recently because of proposed changes to the law, causing more confusion (none of the proposals passed, by the way.) Here’s what you need to know about taxes and selling your home.
What is Capital Gains Tax?
Capital gains tax is what you pay on the profit you make from the sale of an investment. Sale price – purchase price = capital gain. It’s as easy as that.
If you’re under the limit of $500,00 in profit for married couples and $250,000 for singles, you’re in the clear. That’s right—no taxes on the profit you make from selling your home.
A Little History
Pre-1997, things weren’t nearly as rosy for sellers who made a profit on their homes. The only way you could avoid paying taxes on your profit was to buy another, more expensive home within two years of selling your old home. You also had to fill out a form to prove that you were exempt.
The Taxpayer Relief Act of 1997 changed all that, making it easier for people to sell their homes without having to buy new ones. Now, you can use the profit you make on anything you want, and you don’t have to report anything to the IRS if you’re under the limit.
The truth is that most homeowners won’t owe a penny to the IRS over the sale of their home, but there are a few circumstances that will mean you have to pay. So let’s get down to business and go over some of the rules of the law.
Primary Residence Rule
First, the home in question must be your primary residence. You must live in this principal residence for at least two of the previous five years before you sell it.
This means every sale has to be at least two years apart, but you can sell without paying taxes again and again and again.
Rules for Married Couples
If you’re married, it means you are safe from $500,000 in profit from your home’s sale. However, there are a few rules:
Either spouse can meet the ownership test. If you’ve owned your home for the past two years but just added a spouse to the title after getting married a year ago, you meet the ownership test even though your spouse wasn’t an official owner for the full two years.
Both spouse have to meet the use test; they both must live at the residence for two years. If you shared the home for a year before marriage and a year after marriage, you meet the requirement.
If you don’t pass one of these tests, only your single $250,000 waiver will apply.
Also, if either spouse used the exemption in the past two years, the couple cannot use it until the two years has passed.
To arrive at your gain amount, you must establish what’s called your basis in your home.
Your basis in the home is what you paid for the home plus capital improvements you’ve made. These are things that add market value to a home—here’s a helpful list of eligible improvements.
(Important note: if you sold a home before the law change in 1997 and rolled that profit into a home you’re selling now, you must take that amount out of your basis now.)
Next you subtract your basis from what you got from the sale. Take commissions and other selling expenses out of your proceeds from the sale. For example:
Original Sales Price: $300,000
Capital Improvements: $10,000
Basis in Home: $310,000
$500,000 sale price – $30,000 commission – $310,000 basis in home = $160,000 profit
If you must sell before two years because of special circumstances, including employment change, health, or other unforeseen circumstances, you may be eligible for a prorated, tax-free gain.
In cases like these, you’ll calculate the amount of time you met the two-year use test. If you’re transferred to another city after being in the home for just a year, you divide 12/24 and get 0.50. Multiply the married exclusion amount by .50, and you’ll be eligible to exclude up to $250,000 in profit.
A law change in 2003 exempted military personnel from the two-year use requirement, letting them sell tax-free whenever they have to move for the military, something that happens all the time.
Please keep in mind that I’m a loan officer and not a tax professional. This blog post is for informational purposes only and does not constitute legal tax advice. For that, talk with your accountant!